TOWARD A THEORY OF INDUCED INSTITUTIONAL

INNOVATION

by

Vernon W. Ruttan and Yujiro Hayami

Discussion Paper No. 200, February, 1984

Center for Economic Research

Department of Economics

Univers ity of Minnesota

Minneapolis, Minnesota 55455

Draft January 26, 1984

Toward a Theory of Induced Institutional Innovation**

by Vernon ~v. Ruttan and Yuj iro Hayami*

In this paper we elaborate a theory of institutional innovation

in which changes in the demand fot institutional innovation are

induced by changes in relative resource endowments and by

technical change. We illustrate, from agricultural history,

how changes in resource endowments and technical change have

induced changes in private property rights and in the development

of non-market institutions. We also consider the impact of

advances in social science knowledge and of cultural endowments

on the supply of institutional change. In a final section we

present the elements of a model of institutional innovation

that maps the relationships among resource endowments, cultural

endowments, technology, and institutions.

*Professor, Department of Economics and Department of Agricultural and

Applied Economics, University of Hinnesota, and Professor of Economics,

Tokyo ~letropolitan University, respectively. He are indebted to Hargaret

Andre~vs, Robert Bates, David Feeny, Elizabeth Hoffman, Robert Keohane, James

Roumasset and Ford Runge for comments on an earlier draft of this paper.

~'~*To be published in a forthcoming issue of The Journal of Development

Studies.

2

The interpretation of technical and institutional change as

endogenous rather than exogenous to the economic system is a relatively

new development in economic thought.

In work published in the early 1970's we extended the theory of

induced technical change and tested it against the history of agricultural

development in the United States and Japan [Hayami and Ruttan, 1971;

Binswanger and Ruttan, 1978; Wade, 1981]. It is now generally accepted

that the theory of induced technical change provides very substantial

insight into the process of agricultural development for a wide range

of developed and developing countries. And economic historians are

increasingly drawing on the theory of induced technical change in attempt­

ing to interpret differential patterns of productivity growth among

countries and over time [Cain and Paterson, 1981; Phillips, 1982].

The demonstration that technical change can be treated as largely

endogenous to the development process does not imply that the progress of

either agricultural or industrial technology can be left to an 'invisible

3

hand' that drives technology along an 'efficient' path determined by

relative resource endowments. The capacity to advance knowledge in science

and technology is itself a result of a product of institutional innovation-­

'the great invention of the 19th century was the invention of the method of

invention' [Whitehead, 1925:96].

In the case of agriculture, for example, in both Japan and the United

States, much of the technical change that has led to growth of output per

hectare has been produced by public sector institutions. These institutions-­

state (or prefectora1) and federal (or national) agricultural experiment

stations--obtain their resources in the political market place and allocate

their resources through bureaucratic mechanisms. The success of the theory

of induced technical change gives rise, therefore, to the need for a more

careful consideration of the sources of institutional innovation and design.

In this paper we elaborate a theory of institutional innovation in

which shifts in the demand for institutional innovation are induced by

changes in relative resource endowments and by technical change. We also

consider the impact of advances in social science knowledge and of cultural

endowments on the supply of institutional change. After examining the

forces that act to shift the demand and supply of institutional innovation

we then present the elements of a more general model of institutional

change. The perspective on the role of institutional innovation in the

process of economic development presented in this paper is much more

positive than the views that were held by the American institutional school

or in the recent literature on social choice and collective action

[Zingler, 1974; Seckler, 1975; Olson, 1982].

WHAT IS INSTITUTIONAL INNOVATION?

Institutions are the rules of a society or of organizations that

4

facilitate coordination among people by helping them form expectations which

each person can reasonably hold in dealing with others. They reflect the

conventions that have evolved in different societies regarding the behavior

of individuals and groups relative to their own behavior and the behavior

1 of others. In the area of economic relations they have a crucial role

in establishing expectations about the rights to use resources in economic

activities and about the partitioning of the income streams resulting from

economic activity--'institutions provide assurance respecting the actions

of others, and give order and stability to expectations in the complex and

uncertain world of economic relations. ,2

In order to perform the essential role of forming reasonable expecta-

tions in dealings among people, institutions must be stable for an extended

time period. But institutions, like technology, must also change if

development is to occur. Anticipation of the latent gains to be realized

by overcoming the disequilibria resulting from changes in factor endowments,

product demand, and technical change represents powerful inducements to

institutional innovation [North and Thomas, 1970; Schultz, 1975]. Institu-

tions that have been efficient in generating growth in the past may, over

time, come to direct their efforts primarily to protecting the vested

interests of some of their members by maintaining the status quo and thus

become obstacles to further economic deve1opment. 3 The growing disequilibria

in resource allocation due to institutional constraints generated by

economic growth create opportunities for political entrepreneurs or

leaders to organize collective action to bring about institutional change.

Our perspective on the sources of demand for institutional change is

similar to the traditional Marxian view.4

Marx considered technological

s

change as the primary source of institutional change. Our view is somewhat

more complex in that we consider that changes in factor endowments and

product demand are equally important sources of institutional change. Nor

is our definition of institutional change limited to the dramatic or

revolutionary changes of the type anticipated by Marx. Rather, we share

with Lance Davis and Douglass North the view that basic institutions such

as property rights and markets are more typically altered through the

cumulation of 'secondary' or incremental institutional changes such as

modifications in contractual relations or shifts in the boundaries between

market and non-market activities [Davis and North, 1971:9].

There is a supply dimension as well as a demand dimension in institu­

tional change. Collective action leading to changes in the supply of

institutional innovations involves struggles among various vested interest

groups. Clearly, the process is much more complex than the clear-cut,

two-class conflict between the property owners and the propertyless as

assumed by Marx. In our view, the supply of institutional innovations is

strongly influenced by the cost of achieving social consensus (or of

suppressing opposition). How costly a form of institutional change is to

be accepted in a society depends on the power structure among vested

interest groups. It also depends critically on cultural tradition and

ideology, such as nationalism, that make certain institutional arrangements

more easily accepted than others.

Advances in knowledge in the social sciences (and in related professions

such as law, administration, planning, and social service) can reduce the

cost of institutional change in a somewhat similar manner as advances in the

natural sciences reduce the cost of technical change. Education, both

6

general and technical, that facilitates a better understanding among people

of their common interests can also reduce the cost of institutional innovation.

Our insistence that important advances in the understanding of the

processes of institutional innovation and diffusion can be achieved by

treating institutional change as endogenous to the economic system represents

a clear departure from the tradition of modern analytical economics.S

This does not mean that we abandon analytical economics. On the contrary,

we try to expand the scope of modern analytical economics by treating

institutional change as endogenous.

DEMAND FOR INSTITUTIONAL I~TNOVATION--PROPERTY RIGHTS AND MARKET INSTITUTIONS

In some cases the demand for institutional innovation can be satisfied

by the development of new forms of property rights, more efficient market

institutions, or even by evolutionary changes arising out of direct

contracting by individuals at the level of the community or the firm. In

other cases, where externalities are involved, substantial political resources

may have to be brought to bear to organize non-market institutions in order

to provide for the supply of public goods.

In this section we illustrate, from the agricultural history of a

number of countries, how changes in factor endowments, technical change,

and growth in product demand have induced change in property rights and

contractual arrangements in order to promote more efficient resource

allocation through the market.

The agricultural revolution that occurred in England between the 15th

and the 19th centuries involved a substantial increase in the productivity

of land and labor. It was accompanied by the enclosure of open fields

and the replacement of small peasant cultivators, who held their land

from manorial lords, by a system in which large farmers used hired labor

7

to farm the land they leased from the landlords. The First Enclosure

Movement, in the 15th and 16th centuries, resulted in the conversion of

open arable fields and commons to private pasture in areas suitable for

grazing. It was induced by expansion in the export demand for wool. The

Second Enclosure Movement in the 18th century involved conversion of

communally managed arable land into privately operated units. It is now

agreed that it was largely induced by the growing disequilibrium between

the fixed institutional rent that landlords received under copyhold

tenures (with lifetime contracts) and the higher economic rents expected

from adoption of new technology which became more profitable as a consequence

of higher grain prices and lower wages. When the land was enclosed there

was a redistribution of income from farmers to landowners and the dis­

equilibrium was reduced or eliminated. 6

In 19th century Thailand, the opening-up of the nation for international

trade and the reduction in shipping rates to Europe resulted in a sharp

increase in the demand for rice. The land available for rice production,

which had been abundant, became more scarce. Investment in land development

for rice production became profitable. The response was a major transforma­

tion of property rights. Traditional rights in human property (corvee and

slavery) were replaced by more precise private property rights in land

(fee-simple titles) [Feeny, 1982].

In Japan, at the beginning of the feudal Tokugawa period (1603-1867),

peasants' rights to cropland had been limited to the right to till the soil

with the obligation to pay a feudal land tax in kind. As the population

grew, commercialization progressed and irrigation and technology were

developed to make intensive farming more profitable. Some peasants divided

8

their holdings into smaller units and leased them out to ex-servants or

extended family members. Some accumulated land through mortgaging

arrangements that made other peasants de facto tenants. As a result of the

accumulation of illegal leasing and mortgaging practices, peasants'

property rights in land approximated those of a fee-simple title by the

end of the Tokugawa period. -These rights were readily converted to the

modern private-property system in the succeeding Meiji period [Hayami and

Kikuchi, 1982:28].

Research conducted by Yujiro tmyami and Masao Kikuchi in the Philippines

during the late 1970's has enabled us to examine a contemporary example

of the interrelated effects of changes in resource endowments and technical

change on the demand for institutional change in land tenure and labor

relations [Kikuchi and Hayami, 1980; Hayami and Kikuchi, 1982]. The case

is particularly interesting because the institutional innovations occurred

as a result of private contracting among individuals.. The study is unique

in that it is based on a rigorous analysis of micro economic data in a

village over a period of about 20 years.

Changes in technology and resource endowments

Between 1956 and 1976, rice production per hectare in the study village

rose dramatically, from 2.5 to 6.7 metric tons per hectare per year. This

was due to two technical innovations. In 1958, the national irrigation

system was extended to the village. This permitted double-cropping to

replace single-cropping, thereby doubling the annual production per hectare

of rice land. The second major technical change was the introduction in

the late 1960's of the modern high-yielding varieties. The diffusion of

modern varieties was accompanied by increased use of fertilizer and

9

pesticides and by the adoption of improved cultural practices such as

straight-row planting and intensive weeding.

Population growth in the village was rapid. Between 1966 and 1976 the

number of households rose from 66 to 109 and the population rose from 383

to 464, while cultivated area remained virtually constant. The number of

landless laborer households increased from 20 to 54. In 1976, half of

the households in the village had no land to cultivate, not even land for

rent. The average farm size declined from 2.3 to 2.0 hectares.

The land is farmed primarily by tenants. In 1976, only 1.7 hectares

of the 108 hectares of cropland in the village were owned by village

residents. Traditionally, share tenancy was the most common form of tenure.

In both 1956 and 1966, 70 percent of the land was farmed under share tenure

arrangements. In 1963, a new agricultural land reform code was passed

which was designed to break the political power of the traditional landed

elite and to provide greater incentives to peasant producers of basic

7 food crops. A major feature of the new legislation was an arrangement

that permitted tenants to initiate a shift from share tenure to leasehold,

with rent under the leasehold set at 25 percent of the average yield for

the previous three years. Implementation of the code between the mid-1960's

and. the mid-1970's resulted in a decline in the percentage of land farmed

under share tenure to 30 percent.

Institutional innovation

The shift from share tenure to lease tenure was not, however, the

only change in tenure relationships that occurred between 1966 and 1976.

There was a sharp increase in the number of plots farmed under subtenancy

arrangements. The number increased from one in 1956, to five in 1966,

10

and sixteen in 1976. Subtenancy is illegal under the land reform code.

The subtenancy arrangements are usually made without the formal consent

of the landowner. All cases of subtenancy were on land farmed under a

leasehold arrangement. The most common subtenancy arrangement was

fifty-fifty sharing of costs and output.

It was hypothesized that an incentive for the emergence of the subtenancy

institution was that the rent paid to landlords under the leasehold arrange­

ment was below the equilibrium rent--the level which would reflect both

the higher yields of rice obtained with the new technology and the lower

wage rates implied by the increase in population pressure against the land.

To test this hypothesis, market prices were used to compute the value

of the unpaid factor inputs (family labor and capital) for different tenure

arrangements during the 1976 wet season. The results indicate that the

share-to-land was lowest and the operators' surplus was the highest for the

land under leasehold tenancy. In contrast, the share-to-land was the

highest and no surplus was left for the operator who cultivated the land

under the subtenancy arrangement (Table 1). Indeed, the share-to-land when

the land was farmed under subtenancy was very close to the sum of the

share-to-land plus the operators' surplus under the other tenure arrangement.

The results are consistent with the hypothesis. A substantial portion

of the economic rent was captured by the leasehold tenants in the form of

operators' surplus. On the land farmed under a subtenancy arrangement,

the rent was shared between the leaseholder and the landlord.

A second institutional change, induced by higher yields and the increase

in population pressure, has been the emergence of a new pattern of employer-labor

relationship between farm operators and landless workers. According to the

traditional system called hunusan, laborers who participated in the

lnblc 1. F:lctor Shares of Rice Output per Hectare, 1976 l.Jet Season

Number. Factor sharesa

of Area Rice Current Land- Sub- Operators'

Plots (ha) Inputs Total Labor b Surplus Output owner tenancy Capital

kg/ha - -

Leasehold lnnd 44 67.7 2,889 657 567 0 567 918 337 410

(100.0)· (22.7) (19.6) (0) (19.6) (31. 8) (11.7) (14.2)

Share tenancy land 30 29.7 2,749 697 698 0 698 850 288 216

(100.0) (25.3) (25.4) (0) (25.4) (30.9) (10.5) (7.9)

Sub-tenancy land 16 9.1 3,447 801 504 80lc 1,305 1,008 346 -13

I ;-0

(100.0) (23.2) (14.6) (23.2) (37.8) (29.3) (10.1) (-0.4) i-' I

a Percentage shares are shown in parentheses.

b Sum of irrigation fee and paid and/or imputed rentals of carabao, tractor and other machines.

c Rents to sub-leasors in the case of pledged plots are imputed by applying the interest rate of 40 percent

crop season (a mode in the interest rate distribution in the village).

Source: Yujiro Hayami and Masao Kikuchi, Asian Village Economy at the Crossroads: An Economic Approach to

Institutional Change (Tokyo: University of Tokyo Press, 1981, and Minneapolis: University of

Minnesota Press, 1982), pp. 111-13.

12

harvesting and threshing activity received a one-sixth share of the paddy

(rough rice) harvest. By 1976, most of the farmers (83 percent) adopted a

system called gamma, in which participation in the harvesting operation

was limited to workers who had performed the weeding operation without

receiving wages.

The emergence of the gamma system can be interpreted as an institutional

innovation designed to reduce the wage rate for harvesting to a level equal

to the marginal productivity of labor. In the 1950's, when the rice yield

per hectare was low and labor was less abundant, the one-sixth share may

have approximated an equilibrium wage level. With the higher yields and

the more abundant supply of labor, the one-sixth share became larger than

the marginal product of labor in the harvesting operation. 8

To test the hypothesis that the gamma system was adopted rapidly

primarily because it represented an institutional innovation that permitted

farm operators to equate the harvesters' shares of output to the marginal

productivity of labor, imputed wage costs were compared with the actual

harvesters' shares (Table 2). The results indicate that a substantial gap

existed between the imputed wage for the harvesters' labor alone and the

actual harvesters' shares. This gap was eliminated if the imputed wages

for harvesting and weeding labor were added.

Those results are consistent with the hypothesis that the changes in

institutional arrangements governing the use of production factors were

induced when disequilibria between the marginal returns and the marginal

costs of factor inputs occurred as a result of changes in factor endowments

and technical change. Institutional change, therefore, was directed toward

the establishment of a new equilibrium in factor markets.

-13-

TallIe 2. Comparison Bet~.,een the Imputed Value of Harve~;tcrs' Share and /

and Imputed Cost of Gamma Labor.

No. of \vorking days of Gamma labor

a (days/ha)

\\1eeding

Harvesting/threshing

Imputed cost of Gamma labor

(p/ha)b

Weeding

Harvesting/threshing

(1) Total

Actual share of harvesters:

In kind (kg/ha)c

d (2) Imputed value (P/ha)

(2) - (1)

Based on

employers'

data

20.9

33.6

167.2

369.6

536.8

504.0

504.0

-32.8

a Includes labor of family members who Horked as Galluna laborers.

Based on

employees'

data

18.3

33.6

146.4

369.6

516.0

549.0

549.0

33.0

b Imputation using market wage rates (daily wage = P8.0 for weeding, PII.O

for harvesting).

c One-sixth of output per hectare.

d Imputation using market prices (1 kg = Pl).

Source: Yuj iro Hayami and 11<1sao Kikuchi, As ian Vi 11 a~e Economy at the Crossroads:

An Economic Approar.h to Institutional Ch:mge (Tokyo: University of Tokyo

Pres~, 198L and Minneapolis: University of Minnesota Press, 1982), p. 121.

14

Efficiency and equity implications

It is important to recognize that subtenancy and gamma contracts

were the institutional innovations to facilitate more efficient resource

allocations through voluntary agreements by assigning more complet~ private

property rights. The land reform laws gave tenants strong protection of

their tenancy rights with the result that a part of land property rights,

which is the right to continue tilling the soil at a rent lower than the

marginal product of land, was assigned to tenant operators. But the laws

prohibited tenants from renting their land to someone else who might

utilize it more efficiently, when they become elderly or found more profitable

off-farm employment, for example. Subtenancy was developed to reduce such

inefficiency due to the institutional rigidity in the land rental market

based on the land reform programs. Likewise, the gamma system was developed

to counteract the institutional rigidity in the labor market based on the

traditional custom in the rural community in the form of a fixed harvester's

share.

It might appear that these institutional innovations increased effi­

ciency at the expense of equity. But, if the subtenancy system had not

been developed, the route would have been closed for some of the landless

laborers to become farm operators and use their entrepreneurial abilities

more profitably. If the implicit wage rate for harvesting work had been

raised in the absence of the gamma contract, it might have encouraged

mechanization in threshing and thereby reduced employment and labor earnings.

It must be recognized that the institutional innovations to develop more

efficient market by assigning more complete private property rights do

not necessarily impair equity, as is often argued by Marxist and populist

critiques against private market institutions.

15

In the case reviewed here the induced innovation process leading toward

the establishment of equilibrium in factor markets occurred very rapidly

in spite of the fact that many of the transactions--between landlords,

tenants, and laborers--were less than fully monetized. Informal contractual

arrangements or agreements were utilized. The subleasing and the gamma

labor contract evolved without the mobilization of substantial political

activity or bureaucratic effort. Indeed, the subleasing arrangement

evolved in spite of legal prohibition. Where substantial political and

bureaucratic resources must be mobilized to bring about technical or

institutional change, the changes occur much more slowly, as in the cases

of the English enclosure movements and the Thai and Japanese property rights

cases referred to at the beginning of this section.

THE DEMAND FOR INSTITUTIONAL INNOVATION--NON-MARKET

INSTITUTIONS FOR THE SUPPLY OF PUBLIC GOODS

The examples of institutional change advanced in the previous section,

such as the Enclosure in England and the evolution of private property

rights in land in Japan and Thailand, have contributed to the development

of a more efficient market system. Institutional changes of this type are

profitable for society only if the costs involved in the assignment and

prot~ction of rights are smaller than the gains from better resource

allocation. If those costs are very high, it may be necessary to design

non-market institutions in order to achieve more efficient resource

allocation. 9

For example, in Japan, although the system of private property rights

was developed on cropland during the pre-modern period, communal ownership

at the village level permitted open access to large areas of wild and forest

16

land which were utilized for the collection of firewood, leaves, and wild

grasses to fertilize rice fields. However, over time more detailed common

property rules were stipulated for the use of communal land in order to

h . 10 prevent resource ex aust1on.

Detailed stipulations of the time and place of utilization of communal

land as well as rules for mobilizing village labor to maintain communal

property (such as applying fire to regenerate pasture) were often enforced

with religious taboos and rituals. Those communal village institutions

remained viable because it was much more costly to demarcate and partition

wild and forest land than cropland among individuals and to enforce

exclusive use. Any villager's use of communal land involves externality.

For example, his collection of firewood reduces the availability of the

firewood for other villagers. If property rights are not assigned, there

may be only limited incentive for resource conservation. This is not a

serious problem if the resource that is subject to open access is abundant

relative to population. However, as population pressure begins to rise,

a common understanding regarding appropriate use, reinforced by social

sanctions, may act to limit excessive exploitation. But, as population

growth continues to press against limited land resources and the market

value of the resource product rises, it becomes necessary to impose more

formal regulations regarding the access of individual villagers to

communal land.

Group action to supply public goods, such as the maintenance of communal

land, may work effectively if the size of group involved is small, as in

the case of a village community. However, if a large number of people are

involved in the use of a public good, as in the case of marine fisheries,

17

it is more difficult to regulate their resource use or to prevent free

riders by means of voluntary agreements.ll

Action by a higher authority

with coercive power, such as government, may be required to limit free

riding.

The 'socialization' of agricultural research is common not only in

socialist economies but also in market economies [Hayami and Yamada, 1975:

224-49]. This can be explained by the failure of the market in allocating

resources efficiently for the supply of public goods for a large, unidentifiable

clientele group. New information or knowledge resulting from research is

typically endowed with the attributes of a public good characterized by

nonrivalness or jointness in supply and utilization, and nonexcludability

12 or external economies. The first attribute implies that the good is

equally available to all. The second implies that it is impossible for

private producers to appropriate through market pricing the full social

benefits arising directly from the production (and consumption) of the good--

it is difficult to exclude from the utilization of the good those who do not

pay for it. A socially optimal level of supply of such a good cannot be

expected if its supply is left to private firms. However, present institu-

tional arrangements are such that much information resulting from basic

research is nonexcludable. This is the major reason why it has been

necessary to establish nonprofit institutions to advance basic scientific

13 knowledge.

A unique aspect of agricultural research, particularly that directed

to advancing biological technology, is that many of the products of

research--even in the applied area--are characterized by nonexcludability.

Protection by patent laws is either unavailable or inadequate. The nature

18

of agricultural production to be conducted would make it difficult to

restrict information about new technology or practices. Furthermore, even

the largest farms are relatively small units and would not be able to

capture more than a small share of the gains from inventive activity.

Private research activities in agriculture have been directed primarily

toward developing mechanical technology for which patent protection is

established. 14

Another important attribute of the research production function is that

it has a stochastic form. Research, by nature, is characterized by risk

and uncertainty. Success in a research project is like hitting a

'successful oil well.' Any number of dry holes may be bored before the

successful one is found. Richard Nelson has pointed out that this stochastic

nature of the research production function, which is especially strortg in

the case ot basic research, contributes to the failure of the market in

attaining optimum resource allocation over time:

'The very large variance of the profit probability distribution

from a basic research project will tend to cause a risk-avoiding

firm, without the economic resources to spread the risk by running

a number of basic-research projects at once, to value a basic-research

project at significantly less than its expected profitability and

hence, .•. at less than its social value' [Nelson, 1959:3041.

The public-good attributes of the agricultural research product together

with the stochastic nature of the research production function make public

support of agricultural research socially desirable. It does not necessarily

follow, however, that agricultural research should be conducted in govern­

mental institutions financed by tax revenue. The social benefit produced

19

by agricultural research can be measured as the sum of increases in

consumers' and producers' surpluses due to the downward shift in the supply

function of an agricultural product. If the benefit consists primarily

of producers' surplus, agricultural research may be left to the cooperative

activities of agricultural producers (i.e., to the activities of such

institutions as agricultural commodity organizations and cooperatives).

Research on a number of tropical export crops grown under plantation conditions

such as sugar, bananas, and rubber is often organized in this manner.

However, most agricultural commodities are produced by a number of

small producers. Under these conditions voluntary cooperation to support

research would be very costly to organize. Furthermore, most agricultural­

commodities, except those intended for export, are characterized by low price

elasticity of demand. As a result, a major share of the social benefit

produced by research tends to be transmitted to consumers through lower

market prices. In such a situation the cost of agricultural research should

be borne by the general public.

If agricultural research were left entirely to the private sector the

result would be serious bias in the allocation of research resources.

Resources would flow primarily to those areas of mechanical technology that

are adequately protected by patents and to those areas of biological

technology where the results can be protected by trade secrets (such as the

inbred lines used in the production of hybrid corn seed). Other areas,

such as research on open pollinated seed varieties, biological control of

insects and pathogens, and improvements in farming practices and management,

would be neglected. The socialization of agricultural research or the

predominance of public institutions in agricultural researoh, especially

20

in the biological sciences, can be considered a major institutional innovation

designed to offset what would otherwise represent a serious distortion in

the allocation of research resources.

THE SUPPLY OF INSTITUTIONAL INNOVATION

We have identified the disequilibria in economic relationships asso­

ciated with economic growth, such as technical change leading to the genera­

tion of new income streams and changes in relative factor endowments, as

important sources bf demand for institutional change. But the sources of

supply of institutional innovation are less well understood. The factors

that reduce the cost of institutional innovation have not been widely

studied by economists or by other social scientists.

In the Philippines village case discussed earlier, changes in tenure

and labor market institutions were supplied, in response to the changes in

demand generated by changing factor endowments and new income streams,

through the individual and joint decisions of owner-cultivators, tenants and

laborers. But even at this level it was necessary for gains to the innovators

to be large enough to offset the risk of ignoring the land reform prohibitions

against subleasing and the social costs involved in changing traditional

harvest-sharing arrangements. While mobilization of substantial political

r-esources was not required to introduce and extend the new land and labor

market institutions, the distribution of political resources within the village

did influence the initiation and diffusion of the institutional innovations.

The supply of major institutional innovations necessarily involves the

mobilization of substantial political resources by political entrepreneurs

and innovators. It is useful to think in terms of a supply schedule of

institutional innovation that is determined by the marginal cost schedule

21

facing political entrepreneurs as they attempt to design new institutions

and resolve the conflicts among various vested interest groups (or suppression

of opposition when necessary). We hypothesize that institutional innovations

will be suppl~ed if the expected return from the innovation that accrues to

the political entrepreneurs exceeds the marginal cost of mobilizing the

resources necessary to introduce the innovation. To the extent that the

private return to the political entrepreneurs is different from the social

return, the institutional innovation will not be supplied at a socially

. 1 1 15 optl.mum eve.

Thus, the supply of institutional innovation depends critically on the

power structure or balance among vested interest groups in a society. If

the power balance is such that the political entrepreneurs' efforts to

introduce an institutional innovation with a high rate of social return are

adequately rewarded by greater prestige and stronger political support, a

socially desirable institutional innovation may occur. However, if the

institutional innovation is expected to result in a loss to a dominant

political block, the innovation may not be forthcoming even if it is expected

to produce a large net gain to society as a whole. And socially undesirable

institutional innovations may occur if the returns to the entrepreneur or the

inte~est group exceed the gains to society [Tullock, 1967; Krueger, 1974;

Tollison, 1982].

The failure of many developing countries to institutionalize the

agricultural research capacity needed to take advantage of the large gains

from relatively modest investments in technical change may be due, in part,

to the divergence between social returns and the private returns to political

entrepreneurs. In the mid-1920's, for example, agricultural development in

22

Argentina appeared to be proceeding along a path roughly comparable to that

of the United States. Mechanization of crop production lagged slightly

behind that in the United States. Grain yields per hectare averaged slightly

higher than in the United States. In contrast to the United States, however,

output and yields in Argentina remained relatively stagnant between the

mid-1920's and the mid-1970's. It was not until the late 1970's that

Argentina began to realize significant gains in agricultural productivity.

Part of this lag in Argentine agricultural development was due to the dis­

ruption of export markets in the 1930's and 1940's. Students of Argentine

development have pointed to the political dominance of the landed aristocracy,

to the rising tensions between urban and rural interests, and to inappropriate

domestic policies toward agriculture [de Janvry, 1973; Smith, 1969, 1974;:~eavallo

and Mundlak, 1982]. The Argentine case would seem to represent a case

where the bias in the distribution of political and economic resources

imposed exceptionally costly delays in the institutional innovations needed

to take advantage of the relatively inexpensive sources of growth that

technical change in agriculture could have made available.

Cultural endowments, including religion and ideology, exert a strong

influence on the supply of institutional innovation. They make some forms

of institutional change less costly to establish and impose severe costs on

others. For example, the traditional moral obligation in the Japanese village

community to cooperate in joint communal infrastructure maintenance has made

it less costly to implement rural development programs than in societies where

such traditions do not prevail. These activities had their origin in the

feudal organization of rural communities in the pre-Meiji period. But

practices such as maintenance of village and agricultural roads and of

23

irrigation and drainage ditches through joint activities in which all

families contribute labor were still practiced in well over half of the

hamlets in Japan as recently as 1970 [Ishikawa, 1981]. The traditional

patterns of cooperation have represented an important cultural resource on

which to erect modern forms of cooperative marketing and joint farming

activities. Similar cultural resources are not available in South Asian

villages where, for example, the cast structure inhibits cooperation and

encourages specialization.

Likewise, the aspiration of new ideology may reduce the cost to political

entrepreneurs of mobilizing collective action for institutional change. For

example, the Jeffersonian concept of agrarian democracy provided ideological

support for the series of land ordinances culminating in the Homestead Act

of 1862, which established the legal framework designed to encourage an

owner-operator system of agriculture in the American West [Cochrane, 1979:

41-47, 179-88]. Strong nationalist sentiment in Meiji Japan, reflected in

slogans such as 'A Wealthy Nation and Strong Army' (Fukoku Kyohei), helped

mobilize the resources needed for the establishment of vocational schools

and agricultural and industrial experiment stations [Hayami, et al., 1981].

In China, communist ideology, reinforced by the lessons learned during the

guer~ila period in Yenan, inspired the mobilization of communal resources

to build irrigation systems and other forms of social overhead capital

[Schran, 1975]. Thus, ideology can be a critical resource for political

entrepreneurs and an important factor affecting the supply of institutional

innovations.

Advances in social sciences that improve knowledge relevant to the

design of institutional innovations that are capable of generating new

24

income streams or that reduce the cost of conflict resolution act to shift

the supply of institutional change to the right. Throughout history,

improvements in institutional performance have occurred primarily through

the slow accumulation of successful precedent or as by-products of expertise

and experience. Institutional change was generated through the process of

trial and error much in the sa~e manner that technical change was generated

prior to the invention of the research university, the agricultural

experiment station, or the industrial research laboratory. With the

institutionalization of research in the social sciences and related pro­

fessions the process of institutional innovation has begun to proceed much

more efficiently; it is becoming increasingly possible to substitute social

science knowledge and analytical skill for the more expensive process of

learning by trial and error.

The research that led to advances in our understanding of the production

and consumption of rural households in less developed countries represents

an important example of the contribution of advances in social science

knowledge to the design of more efficient institutions [Schultz, 1964;

Ner1ove, 1974; Binswanger, Evenson, F1orencio, and White, 1981]. In a

number of countries this research has led to the abandonment of policies

that viewed peasant households as unresponsive to economic incentives. And

it has led to the design of policies and institutions to make more productive

technologies available to peasant producers and to the design of more efficient

price policies for factors and products.

Similarly, the diffusion of education designed to raise the intellectual

level of the general public and to facilitate better understanding of the

private and social costs of institutional change may reduce the cost to

25

political entrepreneurs of introducing socially desirable institutions and

raise the cost of biasing institutional change in a manner that is costly

to society.

TOWARD A MORE COHPLETE MODEL OF INDUCED INNOVATION

We illustrate, in Figure 1, the elements of a model that maps the

general equilibrium relationships among resource endowments, cultural

d h 1 · d· . . 16 en owments, tec no og1es an 1nst1tut10ns. The model goes beyond the

conventional general equilibrium model in which resource endowments, tech-

nologies, institutions, and culture (conventionally designated as tastes)

are given. 17 In the study of long-term social and economic change the

relationships among the several variables must be treated as recursive.

The formal micro economic models that are employed to analyze the supply and

demand for technical and institutional change can be thought of as 'nested'

within the general equilibrium framework of Figure 1.

One advantage of the 'pattern model' outlined in Figure 1 is that it

helps to identify areas of ignorance. Our capacity to model and test the

relationships between resource endowments and technical change is relatively

strong. Our capacity to model and test the relationships between cultural

endowments and either technical or institutional change is relatively weak.

A second advantage of the model is that it is useful in identifying the

model components that enter into other attempts to account for secular

economic and social change. Failure to analyze historical change in a

general equilibrium context tends to result in a unidimensional perspective

on the relationships bearing on technical and institutional change.

For example, historians working within the Marxist tradition often tend

to view technical change as dominating both institutional and cultural change.

Resource Endowments

r f I

\

-7.6-

Technology

e c I F I

/1 C

\l~~ -0- ---~ Cultural Endowments

Figure 1.

~ __ V Institutions

--- -d-

Interrelationships Between Changes in Resource Endowments,

Cultural Endowments, Technology and Institutions.

27

In his book, Oriental Despotism, Karl Wittfogel views the irrigation

technology used in wet rice cultivation in East Asia as determining political

organization [Wittfogel, 1957]. In terms of Figure 1 his primary emphasis

was on the impact of resource endowments on institutions (C) and (B).

A serious misunderstanding can be observed in contemporary neo-Marxian

critiques of the 'green revolution'. These criticisms have focused

attention almost entirely on the impact of technical change on labor and

land tenure relations. Both the radical and populist critics have emphasized

relation (B). But they have tended to ignore relationships (A) and (c).18

This has led to repeated failure to identify effectively the separate effects

of population growth and technical change on the growth and distribution of

income. The analytical power of the more complete induced innovation model

was illustrated in the work by Hayami and Kikuchi, discussed earlier in this

paper, on the impact of both technical change and population growth on

changes in land tenure and labor market relationships in the Philippines.

Armen Alchian and Harold Demsetz identify a primary function of property

rights as guiding incentives to achieve greater internalization of externali-

ties. They consider that the clear specification of property rights reduces

transaction costs in the face of growing competition for the use of scarce

resources as a result of population growth and/or growth in product demand

[Demsetz, 1967; Alchian and Demsetz, 1973].

North and Thomas, building on the Alchian-Demsetz paradigm, attempted

to explain the economic growth of Western Europe between 900 and 1700

. '1 . f h' ... 19 pr~mar~ y ~n terms 0 c anges ~n property ~nst~tut~ons. During the 11th

and 13th centuries the pressure of population against increasingly scarce

land resources induced innovations in property rights that in turn created

28

profitable opportunities for the generation and adoption of labor-intensive

technical changes in agriculture. The population decline in the 14th and

15th centuries was viewed as a primary factor leading to the demise of

feudalism and the rise of the national state (line C). These institutional

changes in turn opened up new possibilities for economies of scale in

nonagricultural production and in trade (line b).

In a more recent work Mancur Olson has emphasized the proliferation of

'i f' d l' 20 1nstitut ons as a source 0 econom1C ec 1ne. He also regards broad-based

encompassing organizations as having incentives to generate growth and

redistribute incomes to their members with little excess burden. For

example, a broadly based coalition that encompasses the majority of agricul-

tural producers is more likely to exert political pressure for growth-oriented

policies that will enable its members to obtain a larger share of a larger

national product than a smaller organization that represents the interests

of the producers of a single commodity. Small organizations representing

narrow interest groups are more likely to pursue the interests of their

members at the expense of the welfare of other producers and the general

public. In contrast, an even more broadly based farmer-labor coalition

would be more concerned with promoting economic growth than an organization

~epresenting a single sector. But large groups, in Olson's view, are

inherently unstable because rational individuals will not incur the costs

of contributing to the realization of the large group program--they have

strong incentives to act as free riders. As a result, organizational 'space'

in a stable society will be increasingly occupied by special interest

'distributional coalitions'. These distributional coalitions make political

life more devisive. They slow down the adoption of new technologies (line b)

29

and limit the capacity to reallocate resources (line c). The effect is

to slow down economic growth or in some cases initiate a period of economic

decline.

What are the implications of the theory of institutional innovation

outlined in this paper for the research agenda on the economics of

institutional change? In our research on the direction and rate of technical

change we were able to advance significantly our knowledge by treating

technical change as endogenous--as induced primarily by changes in relative

resource endowments and the growth of demand. We have also attempted to

develop a theory of induced institutional innovation in which we treat

institutional innovation as endogenous. There is now a significant body of

evidence that suggests that substantial new insights on institutional

innovation and diffusion can be obtained by treating institutional change

as an economic response to changes in resource endowments and technical

change.

We also insist on the potential significance of cultural endowments,

including the factors that economists typically conceal under the rubric of

tastes and that political scientists include under ideology. But our

capacity to develop rigorous

relative significance of the

empirical tests capab,~of identifying the

relationships betweeniNtultural endowments and

the other elements of the model outlined in Figure 1 is quite unsatisfactory.

Until our colleagues in the other social sciences provide us with more

helpful analytical tools, we are forced to adhere to a strategy that focuses

primarily on the interactions between resource endowments, technical change,

and institutional change. The strategy suggested here does have the clear

advantage of allowing us to explore how far a strategy based on the rather

straightforward extension of standard microeconomic theory will take us in

the analysis of both technical and institutional change.

30

NOTES

1. There is considerable disagreement regarding the meaning of the term

institution. A distinction is often made between the concepts of

institution and organization. We find the broad view which includes

both concepts most useful for our purpose. This is consistent with the

view expressed by both Commons [1950:24] and Knight [1952:51]. Our

definition also encompasses the classification employed by Davis and

North [1971:8-9]. We employ the more inclusive definition in order

to be able to consider changes in the rules or conventions that

govern behavior (a) within economic units such as families, firms and

bureaucracies, (b) among economic units as in the cases of the rules

that govern market relationships, and (c) between economic units and

their environment, as in the case of the relationship between a firm

and a regulatory agency.

2. See Runge [1981b:xv]. Formal analysis of the role of institutions

in providing assurance of stability in economic relationships emerged

from dissatisfaction with the implications of the assumption of strict

dominance of individual strategy in modern welfare economics. See

Sen [1967] and Runge [198la]. In a less formal treatment, North

argues, in a chapter on 'Ideology and the Free Rider Problem', that

shared ideological and ethical perspectives provide assurance that is

lacking in models built on the dominance of individual strategies

[1981:45-58].

3. The role of special interest 'distributional coalitions' in slowing

society's capacity to adopt new technology and reallocate resources

in response to changing conditions is the central theme in Olson [1982:74].

31

4. 'At a certain stage of their development, the material forces of

production in society come in conflict with the existing relations of

production, or--what is but a legal expression for the same thing-­

with the property relations within which they had been at work before.

From forms of development of the forces of production these relations

turn into their fetters. Then comes the period of social revolution.

With the change of the economic foundation the entire immense super­

structure is more or less rapidly transformed' [Marx, 1913:11-12].

For a discussion of the role of technology in Marxian thought see

Rosenberg [1982:34-54].

5. The orthodox view of a generation ago was expressed by Samuelson

[1948:221-22], 'The auxiliary [institutional] constraints imposed upon

the variables are not themselves the proper subject of welfare economics

but must be taken as given.' Contrast this with the more recent

statement by Schotter [1981:6], 'We view welfare economics as a

study ... that ranks the system of rules which dictate social

behavior.' There are now five fairly well defined 'political economy'

traditions that have attempted to break out of the constraints imposed

by traditional welfare economics and treat institutional change as

.endogenous. These include (a) the theory of property rights, (b)

the theory of economic regulation, (c) the theory of interest group

rent seeking, (d) the liberal-pluralist theories of government, and

(e) the neo-Marxian theories of the state. In the property rights

theories the government plays a relatively passive role; the economic

theory of regulation focuses on the electoral process; the rent seeking

and liberal-pluralist theories concentrate on both electoral and

32

bureaucratic choice processes; and the theory of the state attempts to

incorporate electoral, legislative choice, and bureaucratic choice

processes. For a review and criticism see Rausser, Lichtenberg, and

Lattimore [1982].

6. There has been a continuing debate among students of English agricultural

history about whether the higher rents that landowners received after

enclosure was (a) because enclosed farming was more efficient than

open field farming, or (b) because enclosures redistributed income from

farmers to landowners. See Chambers and Mingay [1966], Dahlman [1980],

and Allen [1982].

7. Although the passage and implementation of the Land Reform Code of 1963

was exogenous to the economy of the village, the land reform of the

1960's has been interpreted as the result of efforts by an emerging

industrial elite to break simultaneously the political power of the

more conservative land-owning elite and to provide incentives to

peasant producers to respond to the rapid growth in demand for

marketable surpluses of wage goods, primarily rice and maize, needed

to sustain rapid urban industrial development. Thus, the Land Reform

Code can be viewed as an institutional innovation designed to facilitate

realization of the opportunities for economic growth that could be

realized through rapid urban industrial development. See Ruttan [1969].

8. Real wages for agricultural labor declined significantly between the

mid-1950's and the mid-1960's in the Philippines. See Khan [1977].

Thus, while we cannot be certain that the labor market was in equilibrium

in the 1950's, it is clear that the degree of disequilibrium widened,

as a result of both higher yields and lower wage rates, prior to the

introduction and diffusion of the gamma system.

33

9. Harold Demsetz has pointed out that the relative costs of using market

and political institutions is rarely given explicit consideration in

the literature on market failure. An appropriate way of interpreting

the 'public goods' vs. 'private goods' issue is to ask whether the

costs.'of providing a market are too high relative to the cost of non-market

alternatives. [1964]. A similar point is made by Leonid Hurwicz [1972].

10. For the distinction between open access and common property, see

Ciriacy-Wantrup and Bishop [1975]. In the case of open access use

rights have not been fully established. In the case of common property

rules have been established that govern joint use. Common property is,

therefore a form of land use that lies between the extremes of open

access and fully exclusive private rights. The problem of resource

exhaustion in open access properties was elaborated in Demsetz [1967]

and Alchian and Demsetz [1973].

11. See Olson [1968]. Several students of institutional change have

emphasized that coordinated or common expectations resulting from the

assurance provided by traditional institutions or common assumptions

about equity or ideology have permitted much larger groups to engage

in either implicit or explicit voluntary cooperation than implied by

Olson's model. See Runge [198lb:189-99] and North [1981:54]. North

notes that 'the premium necessary to induce people to become free

riders is positively correlated with the perceived legitimacy of the

existing institution.'

12. For a characterization of the nonrivalness and nonexcludability

attributes of public goods see Samuelson [1954; 1955; 1958] and

Musgrave [1959].

34

13. Nonrivalness is an essential attribute of information. The use of

information about a new farming practice (contour ploughing, for example)

by a farmer is not hindered by the adoption of the same practice by other

farmers. There is no capacity limit for its utilization. Nonexcludability,

in contrast, is not a natural attribute of information but rather is

determined by institutional arrangements. In fact, patent laws are

an institutional arrangement that make a certain kind of information

(called an 'invention') excludable, thereby creating profit incentives

for private creative activities. Retention of trade secrets is another

legally sanctioned method of retaining control over inventions or

other forms of new technical knowledge. These arrangements are the

ones designed to promote more efficient resource allocation through

market arrangements as discussed in the previous section.

14. In a number of countries 'breeders' rights' and 'petty patent' legislation

has induced rapid growth in private sector R&D related to agriculture.

See Ruttan [1982] and Evenson and Evenson [1983].

15. See, for example, Frohlich, Oppenheimer, and Young [1971]. For a

review and extension of concepts of political entrepreneurship see

Guttman [1982].

16. Fusfeld [1980:33] uses the terms 'pattern' or 'Gestalt' model to

describe a form of analysis that links the elements of a general

pattern together by logical connections. The recursive multi-causal

relationships of the pattern model imply that the model is always

'open'--'it can never include all of the relevant variables and

relationships necessary for a full understanding of the phenomenon

under investigation.'

35

17. In economics the concept of cultural endowments is usually subsumed

under the concept of 'tastes' which are regarded as 'given'--that is,

not subject to economic analysis. Our use of the term culture is

consistent with the definition suggested by Leslie A. White, 'When

things and events are considered in the context of their relation to

the human organism, they constitute behavior; when they are con­

sidered • • • in their relationship to one another, they become

culture' [White, 1974:1158]. We use the term cultural endowments to

capture those dimensions of culture that have been transmitted from

the past. Contemporary changes in resource endowments, technology,

and institutions can be expected to result in changes in cultural

endowments.

18. A major limitation of the Marxian model is the emphatic rejection of

a causal link between demographic change and technical and institutional

change [North, 1981:60, 6lJ. This blindness to the role of demographic

factors, and to the impact of relative resource endowments, originated

in the debates between Marx and Malthus. An attempt to correct this

deficiency represents the major innovation of the 'cultural materialism'

school of anthropology. See Harris [1979].

19. See North and Thomas [1970:l-l7a; 1973]. For a critical perspective on

the North-Thomas model see Field [1981]. Field is critical of the

attempt by North and Thomas to treat institutional change as endogenous.

20. See Olson [1982]. For a review of the Olson work see North [1983:163-64].

36

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